Money and Banking

Revised: June 2019

This note is about the nuts and bolts of monetary policy. It is an updated
version of chapter 10 of the manuscript entitled “Macroeconomics: A Modern
Perspective,” by Tom Cooley and Lee Ohanian.

What is money?
A standard way to begin discussions of money is to try to define what it is.
This is somewhat difficult to do because historically many things have been
used as money - shells, beads, cigarettes, pieces of paper. What characteris-
tics make any of these suitable as a form of money? One way to think about
this is to define money in terms of the services it provides. Money is an asset.
An asset is something that serves as a store of value. This means that it can
be used as a way of transferring consumption between periods. But, lots of
things, stocks, bonds, real estate, can and do fulfill that function. Money is
really quite different from other assets because it provides another important
service - it serves as a medium of exchange. The medium of exchange role
implies that it is freely exchanged for goods and services and it has wide ac-
ceptance and (generally) well understood value. Another service that money
provides is that it serves as a unit of account. The role of unit of account
means that when we talk about the value of other assets or consumption
goods we use monetary units as a standard way of denominating them.
How does money come into being and why are people willing to accept
some forms of money? We know that different forms of money have evolved
naturally in many societies. One example that is often cited is that cigarettes
became used as a form of money in prisoner of war camps during World War
II. They are also often used as a form of money in U.S. prisons. What prob-
lems does the existence of an accepted form of money solve? The easiest way
to understand this is to imagine a simple economy in which individuals all
specialize in the production of a single good. Some grow wheat, some har-
vest wood, some raise chickens and some educate the young. The educators
and wood harvesters have to eat, the food producers need wood and need
to educate their young and so on. People benefit from transacting with one
another. But if this were a pure barter world, then transaction could only
take place when we found someone who offered in trade something we desire
and who desired that which we produce. This is called the double coincidence
of wants. The point is that transacting in such a world would be very ineffi-
cient. Suppose, instead that there were some accepted medium of exchange.
It need not be anything with intrinsic value. It could be stones of a cer-
tain size and shape, or pieces of paper embossed with a picture of long dead
politicians. All that is required is that everyone agree that it is the medium
of exchange and agree on its relative value. In this world, educators could
now exchange education services for the type of money and use the money to
purchase wheat and wood without worrying about whether the producers of
wheat and woods that he encountered had any need for education services.
The acceptance of a medium of exchange thus facilitates transactions in the
society because it removes an important impediment to economic activity.
That is why money arises naturally. Now, lets talk about how we measure
it.
Because the distinguishing characteristic of money is its use to facilitate
transactions, a definition of money would include assets commonly used to
facilitate transactions and would exclude assets that are difficult or impossi-
ble to use for transactions. My house, for example, is an asset and a store
of value, but it would be difficult to use for transactions because it is not di-
visible and there may be a lot of uncertainty about its value. Unfortunately,
the distinction between these types of assets is not always very sharp and
it has changed over time because of technology and improved access to in-
formation. Accordingly, there is not a unique empirical definition of money.
Rather, there are several measures that we use and each of them tends to
be useful for some purposes. In what follows we will discuss the monetary
measures that are tracked in the United States. Although the discussion is
specific to the United States these definitions tend to be fairly universally
applied.
The narrowest measure of the money supply counts only government-
issued currency held by the non-bank public. This aggregate is included in
all broader definitions of money and is called the currency component of the
money supply.
A somewhat broader definition of the money supply includes the total
monetary liabilities of the federal government and is known either as high-
powered money or the monetary base, denoted MB. This broader definition
includes currency held by the non-bank public as well as reserves held by
commercial banks as backing for their deposit liabilities. Banks can hold
reserves in either of two forms, vault cash held directly by the commercial
bank and reserve deposits maintained by the commercial bank at one of

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 Monetary Base 823.4

M1 1,383.7
Currency 764.0
Travelers Checks 6.3
Demand Deposits 303.7
Other Checkable Deposits 309.7

M2 7,502.7

Table 1: United States - Measures of Money Supply in December 2007.

the twelve regional Federal Reserve Banks. The Federal Reserve has tight
short-term control over the monetary base but not over broader monetary
aggregates.
A somewhat broader definition of money is known as M1. It includes
currency held by the non-bank public, travelers checks, and checkable de-
posits at commercial banks. (Note that bank reserves do not appear directly
in M1. Instead, they back deposits at commercial banks.) A still broader
definition of the money supply, known as M2, includes M1 plus savings de-
posits, small time deposits (under $100,000), money market mutual fund
shares (MMMFs) held by the public, money market deposit accounts (MM-
DAs), overnight Eurodollar deposits in foreign branches of U.S. banks, and
overnight repurchase agreements whereby a bank sells a security overnight
to a non-bank institution. A still broader definition, M3, includes M2 plus
large certificates of deposit and MMMFs held by institutions.
Table 1 shows the components of the various measures of money as of
December 2007 (figures are in billions of dollars). For comparison, nominal
GDP in 2006 was about $13,195 billion. It is worth noting that what you
might commonly think of as money, currency, is only a small fraction of these
broader measures. But it is clear that all of these other components of money
are available, to some degree or other, for transactions.
For our purposes, the exact definition of the money supply is not crucial.
The important points to note are (a) deposits rather than currency constitute
the largest portion of the broader monetary aggregates and (b) the distinction
between these broader aggregates and the monetary base, over which the

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Federal Reserve has close control. From now on, we will speak only of the
monetary base and the money supply, with the latter being composed of
currency and deposits. For most purposes we need not be specific about
which deposits are included in the definition.

Managing the money supply

In the United States and in most other countries, the supply of money is
controlled by a Central Bank. The U.S. central bank is called the Federal
Reserve. It was established in 1913 by an act of congress and has responsibil-
ity for regulating banks and, most importantly, for formulating and conduct-
ing monetary policy. The Federal Reserve is an independent central bank.
This means that it can formulate and implement policy independently of the
government in power. This arrangement is not true of other countries and
we will discuss the importance of this independence later on. There are 12
regional Federal Reserve Banks and a Board of Governors of the Federal Re-
serve System that resides in Washington D.C.. Since the 1930’s power over
monetary policy has been concentrated in the Federal Reserve Board and
a group called the Federal Open Market Committee (FOMC). The FOMC
consists of the seven Governors of the Federal Reserve System, who are ap-
pointed by the president for staggered 14 year terms, the Chairman, currently
Ben Bernanke, who serves for a four year term and five of the regional bank
presidents who serve on a rotating basis. The FOMC meets every six weeks
and is the group that sets monetary policy.
As noted above, the Federal Reserve directly controls the monetary base.
Through its control of the monetary base and other tools of monetary policy,
the Federal Reserve also influences the short-term behavior of the broader
monetary aggregates and can control their long-run behavior. The Federal
Reserve’s short-run control over aggregates broader than the monetary base
is far from perfect, and commercial banks and the non-bank public can have
a substantial effect on the short-term behavior of the broader monetary ag-
gregates. Historically banks were at center of the financial system and the
Federal Reserve had substantial control over the provision of credit in the
economy. In recent years, however, the role of non-bank financial institutions
such as insurance companies and pension funds has increased and these in-
stitutions and the credit they provide are not subject to the influence of the
Fed.
We will illustrate in some detail how the Fed implements monetary policy.

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Before we do that, it will be useful to describe the features of a banking
system where deposits must be backed by reserves.
The United States has what is called a fractional-reserve banking system,
meaning that commercial banks have to hold reserves equal only to a fraction
of their deposit liabilities. Banks hold reserves for two reasons. First, because
they must be able to honor demands for cash by their depositors. Second, in
the U.S. and in many other countries, they are required to maintain certain
reserves. The amount of such required reserves has varied tremendously over
time and it varies tremendously across countries. In Canada and the U.K.
for example, banks are not required to maintain any set fraction of deposits
as reserves. Of course this doesn’t mean the banks in those countries don’t
maintain reserves because they still do so for the first reason cited. Variations
in reserve requirements have at various times been an important tool of
monetary policy. How those variations affect the economy is an important
topic that we will discuss further. The significance of the fact that banks only
have to keep fractional reserves is that banks can use a dollar of reserves to
back several dollars of deposits. We now examine how commercial banks use
additional reserves to create deposits.
The table below illustrates a highly simplified balance sheet of a com-
mercial bank. The major asset categories are reserves, earning assets, and
buildings and facilities. Reserves earn no interest. The two main types of
earning assets are loans made by the bank and securities (mainly government
debt) held by the bank. The bank’s major liability is deposits held for its
customers.

Bank Balance Sheet

Assets Liabilities
Reserves Deposits
Required
Excess
Earning Assets
Securities
Loans
Buildings, etc. Net Worth

Suppose we decided to start a student bank, to be run by the association

of students. Initially all items on the balance sheet of Student Bank are zero.
(For simplicity, we do not explicitly show net worth, securities, buildings

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and facilities, etc., on the balance sheet.) Now suppose that our customers
deposit $1,000,000 of currency in the Bank (these are well-to-do students
or there are lots of them!). This currency (now vault cash) counts as a
part of Student Bank’s reserves. Suppose that the only regulation this bank
faces is that it must maintain a certain fraction of its deposit as reserve. If
the required reserve ratio is 0.2, Student Bank now has required reserves of
$200 and excess reserves of $800. The following table shows the bank’s new
balance sheet. Because these reserves earn no interest, the bank wishes to
convert its excess reserves into earning assets.

Student Bank
Assets(000’s) Liabilities (000’s)
Reserves 1,000 Deposits 1,000
Required 200
Excess 800
Loans 0

But, the bank was formed to make some money and provide services to
other students. Student Bank can convert its excess reserves into earning
assets by making a loan. Suppose that Hillary, a customer of Student Bank,
comes to the bank and applies for an $800,000 loan to invest in some vacation
real estate in Arkansas. The bank’s credit review committee approves the
loan and credits Hillary’s checking account with $800,000. The bank’s de-
posits increase to $1,800,000, its required reserves increase to $360,000, and
its excess reserves fall to $640,000. The table below shows the new balance
sheet of Student Bank.

Student Bank
Assets (000’s) Liabilities (000’s)
Reserves 1,000 Deposits 1,800
Required 360
Excess 640
Loans 800

Hillary now goes to the real estate developer and writes a check for
$800,000 to pay for her part of the investment. The developer deposits the
check in his account at Ozark Bank. When the check clears, Student Bank
must transfer $800,000 in cash to Ozark Bank. Student Bank loses deposits

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and reserves of $800,000, while Ozark Bank gains deposits and reserves in
the same amount. The balance sheets of the two banks are shown below.
Notice that Student Bank now has no excess reserves, while Ozark Bank has
excess reserves of $640,000.

Student Bank Ozark Bank

Assets (000’s) Liabilities (000’s) Assets (000’s) Liabilities (000’s)
Reserves 200 Deposits 1,000 Reserves 800 Deposits 800
Required 200 Required 160
Excess 0 Excess 640
Loans 800 Loans 0

Ozark Bank now converts its excess reserves into earning assets by making
a loan of $640,000, to Bill, leaving it with the following balance sheet:

Ozark Bank
Assets (000’s) Liabilities (000’s)
Reserves 800 Deposits 1,400
Required 288
Excess 512
Loans 640

The borrower, Bill spends this $640,000 with various merchants who de-
posits their funds in Arkansas Bank. When everything clears, these two
banks are left with the balance sheets shown below.

Ozark Bank Arkansas Bank

Assets (000’s) Liabilities (000’s) Assets (000’s) Liabilities (000’s)
Reserves 160 Deposits 800 Reserves 640 Deposits 640
Required 160 Required 128
Excess 0 Excess 512
Loans 640 Loans 0

This process, which is repeated again and again, is known as the bank
credit expansion process because the supply of bank credit increases at each
step. Each increase in bank lending causes an equal increase in deposits and

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the money supply. Banks are unique among financial institutions because
their lending activities increase the money supply.
What is the end result of the credit expansion process? Deposits in-
crease at each stage of the process, and the total increase in deposits is
$(1,000,000 + 800,000 + 640,000 + 512,000 + ...) = $5,000,000. Total
bank reserves increase by $1,000,000 in the initial stage and then increase
no further. The $1,000,000 of additional reserves is just redistributed among
different banks. The end result is that $1,000,000 of additional bank reserves
supports $5,000,000 of additional deposits. This result is due to the fact that
the reserve ratio is 0.2, so that each dollar of reserves can support five dollars
of deposits.

The Money Multiplier

In the above example, we implicitly assumed that each bank customer held all
of his or her money in deposits. What would have happened if each depositor
had held a mix of deposits and currency? To be specific, suppose the real
estate developer had deposited only $600,000 in Ozark Bank and had held
$200,000 in currency (perhaps to make political contributions!). Ozark Bank
would have had 25 percent fewer excess reserves and would have created
fewer deposits. In addition, each subsequent bank would have created 25
percent less deposits. The net result is more currency, fewer deposits, and
less total money in the system. How do we know that the decline in deposits
outweighs the increase in currency, resulting in a smaller total money supply?
The reason is that each dollar held by the public in currency removes one
dollar in reserves from the banking system, and each dollar of reserves (under
the assumption of a reserve ratio of 0.2) can back five dollars of deposits.
We could illustrate this result by following an initial deposit of $1,000,000
through several different banks, as in our previous example, but an exam-
ple with both currency and deposits would get very messy. This simplest
illustration is algebraic. We will use the following notation:
M = the money supply
C = the currency component of the money supply
D = deposits
H = high-powered money (the monetary base)
R = bank reserves
c = the ratio of currency to deposits
rr = the ratio of reserves to deposits (the reserve ratio)

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 The money supply is equal to deposits plus currency:

M = D + C.
The monetary base is divided between currency and bank reserves:

H = C + R.
Banks hold reserves equal to a fraction of their deposits:

R = rrD.
The public holds currency equal to a fraction of deposits:

C = cD.
Substituting for currency, the money supply is given by:

M = D + cD = (1 + c)D.
Substituting for currency and reserves, the monetary base is given by:

H = cD + rrD = (c + rr)D.
The ratio of the money supply to the monetary base is called the money
multiplier and is equal to

M (1 + c)
m= = .
H (c + rr)
The money multiplier tells us how much each dollar of the monetary
base can support. In our first example, people hold no currency (c = 0)
and the reserve ratio is 0.2, so that the money multiplier is five. Suppose
that the Federal Reserve injects six dollars into the financial system. The
six dollars, when deposited in the banking system, is multiplied through the
credit expansion process into 30 dollars of deposits.
If people hold currency equal to 20 percent of deposits (c = 0.2) and
the reserve ratio is still 0.2, then the money multiplier is only three. If the
Federal Reserve injects six dollars of high-powered money into the system,
the public initially holds one dollar in currency and deposits the remaining
five dollars in the banking system. Through the credit expansion process, the

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banking system multiplies this five dollars of reserves into a larger amount
of deposits. However, at each step of the process, the public withdraws some
money from the banking system so as to keep its currency holdings equal
to 20 percent of deposits. Each of these currency withdrawals reduces bank
reserves, so that the banking system can create fewer deposits at each stage
of the credit expansion process. In the end, the money supply expands by
only 18 dollars, three dollars of which is currency and 15 dollars of which is
deposits. Because high-powered money increases by six dollars and currency
holding increase by only three dollars, the remaining three dollars find their
way into the banking system as reserves. The additional reserves are exactly
equal to the amount banks must hold to back the 15 dollars of new deposits.

The Balance Sheet of the Central Bank

In the previous discussion we followed money through individual banks with-
out explicitly acknowledging the role of the central bank - the Federal Reserve
- in the process. Now, let us look at the banking sector as a whole and the
role of the central bank in changing the money supply.
The following table illustrates the entries in the aggregate balance sheet
for the banking sector of a country:

Banking Sector
Assets Liabilities
Reserves Deposits
Required Demand Deposits
Excess Time Deposits
Borrowing from
Cash Central Bank
Securities Other
Loans

This is just like the balance sheets considered above except that now we
have expanded the range of assets and liabilities that a bank has. Bank
reserves here represent the banking sector’s deposits with the central bank.
The securities can make many forms but include securities issued by the
government. Now let us look at the balance sheet of the central bank.

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 Central Bank
Assets Liabilities
Securities Currency
Loans to Banks Reserves
Foreign Exchange Other Deposits

The banks assets include government securities, loans to member banks,

and foreign exchange reserves. The latter includes deposits abroad, foreign
denominated securities, and deposits with other central banks. The banks
liabilities include currency issued, reserves deposited by member banks and
other deposits. In the U.S., the Federal Reserve by law cannot pay interest
on reserves.

The Tools of Monetary Policy

The Central Bank has three main tools with which to influence the money
supply. The most important is open market operations, through which the
Central Bank buys and sells federal government debt securities on the sec-
ondary market. In the U.S. these securities are issued by the U.S. Treasury
and certain government agencies, but the Federal Reserve is prohibited from
purchasing government debt directly when issued. The Central Bank uses
open market operations to control the monetary base. For example, let’s as-
sume the Central Bank buys $100 million of government bonds from private
banks. It pays for those bonds by crediting the private banks accounts at
the Central Bank. Such accounts are part of both bank reserves and the
monetary base. The effect is shown in the two balance sheets below:

Banking Sector
Assets (000’s) Liabilities (000’s)
Reserves Deposits
Required Demand Deposits
Excess +100,000 Time Deposits
Borrowing from
Cash Central Bank
Securities -100,000 Other
Loans

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 Central Bank
Assets (000’s) Liabilities (000’s)
Securities +100,000 Currency
Loans to Banks Reserves +100,000
Foreign Exchange Other Deposits

The private banks can now use the additional $100 million of reserves to
back additional deposits by the public. They have excess reserves so they are
free to make additional loans to customers, thereby increasing the amount of
money or “liquidity” in the economy in the way we illustrated in our earlier
simple example. The net result is that an open market purchase expands the
monetary base and increases bank reserves.
Conversely, if the Central Bank sells government securities that it holds to
the private banking sector it has the effect of decreasing the monetary base.
An open market sale of securities by the Central Bank causes a reduction in
bank reserves and the monetary base.
The Central Bank’s second tool of monetary control is reserve require-
ments. The Central Bank can require banks to hold reserves equal to some
fraction of their deposits. If it raises the required reserve ratio (i.e., the ratio
of reserves to deposits), the Central Bank reduces the amount of deposits
that banks can support with a given stock of reserves. This has the effect of
reducing the amount of money that is available for lending and thus reducing
the money supply. In practice changes in reserve requirements have not been
used much as an instrument of monetary policy for some time. In Canada
and the United Kingdom required reserves are zero. In the United States
reserve requirements for time and savings deposits were eliminated in 1990.
If a commercial bank’s actual reserves are below the level required by the
Central Bank, the bank can borrow additional reserves either from the Cen-
tral Bank or from another commercial bank that has excess reserves. In the
U.S. such interbank loans are known as federal funds, and the interest rate
on these loans is known as the federal funds rate. The U.S. Federal Reserve’s
borrowing facility is known as the discount window, and the associated in-
terest rate is the discount rate. Changes in the discount rate are the Federal
Reserve’s third tool of monetary control. By raising the discount rate, the
Federal Reserve can discourage banks from borrowing at the discount win-
dow, thus making banks less aggressive in creating deposits. In addition,
the Federal Reserve can informally discourage what it regards as excessive
commercial bank borrowing at the discount window.

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 How does the description just given fit with our understanding of how
monetary policy works in practice? In the United States the policy decisions
made at meetings of the Federal Open Market Committee are usually stated
in terms of interest rates. For example, at the meeting held on December
11th, 2007, the FOMC decided to lower the “Target level” for the Federal
Funds Rate and the Discount Rate each by 25 basis points. Thus, the stated
policy is to lower the Federal Funds rate by 25 basis points or one quarter
of one percent. Such a policy is implemented by conducting open market
operations that have the effect of injecting reserves (and hence liquidity) in
the system to the point at which the market rate for federal funds - reserves
borrowed from other banks or from the Fed, decreases by twenty five basis
points. For that reason the specific goals of monetary policy are stated in
terms of an interest rate rather than the size of a monetary aggregate or the
amount of reserves in the system. The Discount Rate is the rate at which
the Fed is willing to lend reserves to member banks.
These examples illustrate the role of the Central Bank, the banks, and the
public in the money supply process. The Central Bank controls the monetary
base and sets minimum required values for the reserve ratio. As a matter of
prudence, banks generally hold some reserves above the minimum required,
but they can vary the amount of excess reserves they hold and the volume
of new loans and deposits they generate. These decisions affect the money
multiplier through their effect on the reserve ratio. Finally, the public can
significantly alter the money multiplier by changing the mix of currency and
deposits it holds.

The Management of Reserves

In some ways this idea of the money multiplier depending on the amount
of required reserves is outdated. In the U.S. required reserves are about ten
percent. But, even these reserve requirements may not really be binding
for banks. And, as we noted above, in many countries, Canada being one
example, required reserves are zero.
It is interesting to think about the issue of reserves from the point of
view of the bank. As we discussed earlier, banks still hold reserves so they
can honor transactions made by customers. If I write a check to pay a
bill or use my debit card to purchase something, the bank must honor it
immediately. Clearly it would be unacceptable for them to argue that I have
to wait because they are temporarily short of funds. So, they are motivated

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to hold reserves. But, if the required level of reserves is greater than what
they need to cover transactions they are unhappy because those reserves do
not earn any interest.
How do banks respond to this mismatch between required reserves and
desired reserves? Recall, that banks are no longer required to hold reserves
for time deposits or for money market deposit accounts. In response to the
mismatch between required reserves and desired reserves banks have created
sweep accounts. At the end of the day they can sweep excess funds from
checking accounts, which are subject to reserves requirements, into money
market accounts that are exempt from reserve requirements. The end result
of this is that reserves will be reduced toward the level that is needed to meet
transactions demand.
Because banks are able to operate closer to their margins, they are likely
to go into the markets for reserves more often. A bank that inadvertently
finishes a day with too few reserves can avoid penalty by borrowing reserves
from other banks in the Federal Funds Market. Or, the bank can borrow
money from the Federal Reserve through the Discount Window. Similarly, a
bank which ends the day with too many reserves is likely to be a net lender
in the Federal Funds market. The increased use of sweeps accounts has the
effect of causing more activity in the Federal Funds Market and potentially
causing the Federal Funds rate to be more volatile. Some observers have
worried that the use of sweeps complicates the implementation of monetary
policy by making specific targets for the funds rate more difficult to hit. To
counter this possibility that reserve management might make the Federal
Funds rate more volatile, the Fed has changed the period over which banks
calculate their reserves.

Other Functions of A Central Bank

The discussion so far has focused mainly on the role of the Central Bank in
the money supply process. In the United States and in most other countries
the Central Bank has other important duties as well. Typically Central
Banks have some responsibility for the supervision and regulation of banks.
It has a responsibility to guarantee the soundness of the banking system and
with that role in mind it regulates the actions of member banks to make
sure that they remain financially sound. Bank regulation usually takes three
forms.
Banks are required to meet minimum capital requirements. These specify

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the ratio of capital to bank assets. There are international standards for the
minimum ratio of capital to risk adjusted assets that are by the Bank for
International Settlements.
Bank examination is often an important function of the central bank.
Bank portfolios are reviewed periodically to make certain that banks ade-
quate reserves for losses on risky loans.
Finally, Central Banks usually provide lender of last resort facilities for
banks that are solvent but may be illiquid because of the fact that they
tend borrow short term but make long term loans. In many countries the
difficulty is to decide when banks are indeed solvent or whether they are
simply illiquid, and then there is problem of deciding what to do about it.
That is a topic worthy of extensive discussion in itself but it would take us
too far afield from our primary objective.
Finally, in some countries, notably the U.S., the Central Bank is responsi-
ble for the regulation of banking structure. That is, it oversees the acquisition
of banks and non-banking businesses by bank holding companies. For many
years and for historical reasons there was a fear of consolidation in the bank-
ing industry and of the expansion of banks into related financial activities.
In recent years many of the barriers to these activities have been removed,
and this function of the Fed has changed.
———————————————————————–
Thanks to Gian Luca Clementi, Dave Backus, and NYU Stern School of
Business for sharing material for these notes.

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